AEI-BROOKINGS JOINT CENTER FOR REGULATORY STUDIES

Randall S. Kroszner is a Professor of Economics at the Graduate School of Business, University of Chicago, and a Non-Resident Scholar at the American Enterprise Institute. The author thanks Robert Hahn for helpful comments, and Sharon Utz and Sasha Gentling for research assistance.

Executive Summary

The objective of any changes to the rules governing the nomination and election of board members should be to increase shareholder value. The Security and Exchange Commission's proposed rules on shareholder access add little to achieving this goal and have some potentially large downside risks. Rather than promulgate a new set of regulations governing the inclusion of nominees of significant shareholders in company proxy materials, the focus of reforms should be on reducing inappropriate barriers for beneficial involvement of significant shareholders in the corporate governance of publicly-traded firms.

The Securities and Exchange Commission (SEC) has proposed rules mandating that in particular circumstances companies include in their proxy materials candidates for directorships proposed by shareholders. Currently, companies are not required to include such shareholder nominees, so shareholders proposing an alternative director must directly bear the costs of obtaining the list of voting shareholders, printing and mailing their materials, etc. Under the proposed rule, companies would be required to include shareholder nominees only if specific "triggering events" occur: (1) At least 35 percent of votes were withheld from a company's nominee for a directorship; (2) A proposal by a shareholder or group of shareholders (owning a minimum 1 percent of shares for at least 1 year) received a majority of votes cast but was not implemented by the board before the next proxy round; or (3) A proposal by such a shareholder or group to adopt this "direct access" nomination procedure received a majority of votes cast. After a triggering event occurs, an "eligible" shareholder or group -- defined as owning a minimum of 5 percent of the shares for at least 2 years -- could then submit nominees that would have to be included in the company's proxy materials. Such nominees could not be employed by or paid by the proposing shareholder or group. The number of such nominees would be limited to between 1 and 3 people, depending upon the size of the board, but in any case would be less than a majority of the directors.

To evaluate the proposed rules, the key questions are: what is the objective of the proposal, is this goal a worthy one, and, if so, does the rule achieve the goal with a reasonable balancing of costs and benefits. I will argue that the proposed rules do little to achieve a worthy objective. Instead of promulgating new rules with uncertain consequences, the most appropriate direction of reform would be to reduce statutory and regulatory disincentives to active monitoring by significant shareholders and to make it easier and legally safer for such shareholders to play a meaningful role in corporate control contests.1

2. Objectives of Reform

The objective of any changes to the rules governing the nomination and election of board members should be to change corporate governance so that the result is improved shareholder value. I believe that the proposal falls far short of achieving such a goal and may even be contrary to it.

Shareholders have numerous responses if they are dissatisfied with the management of a publicly-traded corporation. Shareholders may "vote with their feet" and sell their shares or refrain from purchasing shares. Such a response would be reflected in a lower share valuation, which would then leave the corporation more vulnerable to a second form of market discipline, namely, a tender offer or takeover. Shareholders could tender their shares to a would-be acquirer who would alter the management of underperforming assets. A proxy contest is a third approach and that is the focus of the current shareholder access proposal.

Given the importance of indexing today, the "exit" option simply to sell shares or refrain from buying may not be feasible for many institutional investors. Large mutual funds that promise to track indexes such as the S&P 500 or the Dow Jones Industrials cannot avoid holding significant ownership of the companies comprising the most important components of those indexes. Some foundations, families, or individuals may also have particular reasons or obligations to maintain a significant ownership stake in a particular company. It is then particularly valuable to assess whether the proposed rules would help such institutional or individual investors to exercise an enhanced and beneficial influence on management and, ultimately, shareholder value. There is little reason to believe that this will be the case.

3. The Boardroom is not like Congress

Shareholder access proposals such as those currently put forward by the SEC are sometimes characterized as enhancing "shareholder democracy." Arguments in favor of the proposals often implicitly draw from the logic of the benefits of democracy in the political context, but many of these analogies are false or inappropriate in the corporate context. While "democracy" in a political system may be a worthy goal, greater "democracy" or "access" in and of itself may not have the same value in the corporate system. First, as the Federalist Papers discuss in detail, the US Constitution attempts to achieve a balance of interests within the polity. Different groups have competing and often conflicting objectives, and the political process should respect and represent these diverse interests in working toward solutions to problems that require collective action. In contrast, the objective of management is quite clear: officers and directors of publicly-traded firms are the fiduciaries of the shareholders and have an obligation to act in their interest. The interest of shareholders is to maximize shareholder value. While there may be much disagreement over what strategies, investments, and management techniques will achieve the goal, the objective is not one that is subject to dispute. This commonality of interest is much in contrast to the political context where different groups of citizens may subscribe to conflicting ideologies and do not share similar goals and aspirations.

In the context of democracy, thus, it may be important and valuable to adopt institutions and structures to ensure access to the political process by groups representing alternative viewpoints, thereby enriching the political debate. In the corporate context, however, representation of and by different groups does not have the same value given the fiduciary duties of officers and directors to pursue the common goal of improving shareholder value.2 The boardroom should not be thought of the same way as Congress.

Second, an appropriate balance has to be struck between a "democracy" and a "republic." The US Constitution does not provide for a direct democracy but sets up a republican form of government in which political decisions are largely left to elected representatives. Some state constitutions, however, permit more opportunities for "direct democracy" through the ability to have referenda or "citizen initiatives" included on ballots, to have recall votes on previously elected politicians (as California recently illustrates), to have one's name on the ballot at relatively low cost in terms of gathering signatures, etc. States also have different nomination and primary procedures. There is no consensus in the research on this topic as to whether greater opportunities for direct democracy and easier access to the ballot improve political outcomes.3 Given this mixed evidence, even if the analogy from the political context were appropriate, one could not conclude that greater shareholder access would have beneficial effects in the corporate context.

4. Misplaced Focus with Potential Costs that Outweigh Benefits

In terms of the economics of corporate governance, the proposal does not address the key disincentives for significant shareholders to become more involved in corporate governance to improve shareholder value. If the proposed rules had been in place for, say, the last decade, there is little reason to believe than they would have helped to prevent or even mitigate any of the recent corporate scandals and examples of accounting fraud that have been the motivation for the public and private corporate governance reforms during the last two years. Lowering the cost for significant shareholders to have their nominees included in the company's proxy materials, in certain circumstances, is not an effective way to improve corporate governance and entails a number of downside risks.

The proposed rules could increase the costs of the proxy process, and the potential for contested elections might discourage qualified directors from standing for election. The costs of Director and Officer liability insurance might rise, and companies might have to provide greater compensation to attract qualified directors. Contested elections and shareholder slates could lead to fragmentation of the board and might disrupt the decision-making process. Also, such a proposal could bring "special" or "narrow" interest pressure on the management of a firm that would move them away from, rather than towards, the objective of maximizing shareholder value.

Although none of these costs are likely to be large under the current proposal, the arbitrary nature of the various threshold levels in the proposal invite tinkering that could increase these costs significantly and generate uncertainty. There is no economic or legal basis, for example, for choosing a 35 percent "withhold approval" vote threshold for a triggering event. If the rules were to be adopted but with little impact, there might be pressure to reduce substantively the threshold level or even to eliminate the requirement of triggering events. Similarly, the requirement that a shareholder proposal triggering enhanced "access" must be sponsored by a shareholder or group that has owned 1 percent of the shares for at least 1 year has no analytical basis. The choice of a 5 percent stake over two years as necessary to become eligible to have nominees included in the company's proxy materials also is an arbitrary requirement. If the "triggering events" are too weak or eliminated and the threshold for a shareholder or group to propose nominees too low, then "shareholder access" rules may lead to special interest lobbying from particular groups which would be disruptive and costly.4 Some commentators have suggested that the SEC proposal is simply a starting point and already envision threshold changes in the future if the rules were to be adopted.5

5. The Right Focus: Reducing Disincentives for Significant Shareholder Involvement

Instead of new regulations, searching for barriers in existing laws would be the most effective step toward having large shareholders become more active in improving corporate governance and shareholder value. The following Table, reproduced from the 2003 Economic Report of the President, provides a valuable summary of various legal obstacles or disincentives to a more active role in corporate governance faced by institutional investors.6

The Investment Company Act of 1940, for example, substantially constrains the ability of institutions to discipline corporate management on behalf of households and other investors. This restriction appears to have arisen from a desire to promote diversification of institutional holdings and to limit institutions' influence over corporate managements. Modern financial economics research has helped to clarify what conditions must exist for diversification to occur. The evidence is that the Act's restrictions go far beyond what is required to ensure diversification. The law governing private pension funds, ERISA, as well as state-level insurance regulation also involve similar discouragements. In their current forms, such laws and regulations thus impose costs on investors - and on modern corporate governance - without countervailing benefits to investors or to the functioning of the market generally.

The Gramm-Leach-Bliley Act of 1999 reduced long-standing barriers on commercial banks owning equity stakes in non-financial corporations by permitting Bank Holding Companies (BHCs) to become "Financial Holding Companies" and avoid restrictions on BHCs as noted in the Table. Banks, however, have neither become significant equity owners nor active participants as might be expected in the corporate governance of non-financial firms. At least part of this reluctance can be attributed to lender liability and equitable subordination doctrines in bankruptcy law.7 If a bank is found to have been active in firm management and acted "inequitably" prior to a borrower's bankruptcy, the bank can lose seniority in its claims against the bankrupt firm. Board representation and/or equity ownership by the bank subjects the bank to "heightened scrutiny" in these actions.8 In addition, a bank actively involved in firm management potentially faces liability for losses to other claimants that can be attributed to its actions. The courts can and sometimes do go further to assess punitive damages in lender liability cases (see Farmers & Merchants Bank of Centre v. L. W. Hancock, 506 So.2d 305, 1987).9

Since banks would not wish to jeopardize their senior creditor status nor expose themselves to lawsuits from other creditors of the distressed firm, banks will have an incentive to maintain an "arm's length" from the firm. The relevant legal code provides no explicit statutory guidance about what type of conduct would trigger subordination or lender liability, and the case law has not established bright line rules.10 According to one commentator,11 only complete passivity prior to formal bankruptcy filing can protect the creditor against such actions.12

More generally, institutional investors, financial institutions, and significant shareholders can be subject to lawsuits if they become actively involved in the corporate governance of firms. Such suits are common in takeover and control contests, not simply in bankruptcy situations. Although concerns about potential conflicts of interest between significant shareholders and other shareholders may exist, the potential litigation costs of becoming actively involved even in actions that would lead to improved shareholder value discourage many significant shareholders from doing so.13

6. Conclusion

The last two years have witnessed the most sweeping reforms of the US corporate governance system -- in terms of statute, regulation, self-regulatory organization rules, and individual corporate responses -- in at least 70 years and perhaps ever.14 Much as been done to enhance management accountability to provide incentives to deter fraud and improve shareholder value. The current SEC proposed rules on "shareholder access" add little to achieving these objectives and have some potentially large downside risks. Rather than promulgate a new set of regulations governing the inclusion of nominees of significant shareholders in company proxy materials, the focus of reforms should be on reducing inappropriate barriers for active beneficial involvement of significant shareholders in the corporate governance of publicly-traded firms.

No more than 2 percent of assets may be in the common stock of a single company; no more than 20 percent of assets may be in equity interests.

No more than 2 percent of assets may be in a single company's preferred or guaranteed stock; at most, 10 percent of assets may be in common stock.

State Law
(New York example)
NY Insurance Law (for
insurers doing business
in NY)

Same

Mutual funds

For half of portfolio: no more than 5 percent of fund's assets can go into stock of any one issuer and fund may not purchase more than 10 percent of voting stock of any company, otherwise tax penalties apply.

Must get SEC approval prior to joint action with affiliate, e.g., a fund needs SEC approval before acting jointly to control a company of which it and its partner own more than 5 percent.

Subchapter M of the
Internal Revenue Code

1940 Investment Company
Act

Pensions

Must manage assets prudently, and generally requires that assets be diversified. The "prudence rule" has been interpreted to require that a person responsible for a plan retain experts when appropriate, and is a significantly higher standard than the business judgment rule.

Must act for the exclusive purpose of providing benefits to participants and beneficiaries.

Traditional pension plans may not acquire any stock or bonds issued by the company that sponsors the plan if such acquisition would cause the plan to hold more than 10 percent of its assets in such securities.

These rules are supplemented by rules that specifically prohibit potentially abusive transactions with the plan.

ERISA:

29 U.S.C. § 1104 (a)(1)(B)
29 U.S.C. § 1104 (a)(1)(C)

29 U.S.C. § 1104 (a)(1)(A)

29 U.S.C. § 1107 (a)(2)

29 U.S.C. § 1106 (a);
1106 (b)

Bank holding companies (BHC)

Bank holding companies generally cannot acquire direct or indirect ownership or control of any voting shares of any company that is not a bank. Several important exceptions exist which, for example, permit a BHC to hold shares of a company:

That do not exceed 5 percent of the company's outstanding shares, if the ownership does not constitute "control."

Engaged in activities closely related to banking.

Bank Holding Company Act
of 1956

12 U.S.C. § 1843(c)(6)

12 U.S.C. § 1843(c)(8)

Bank trust funds

For pension accounts, no more than 10 percent of assets may be in employer securities.

Active bank control could trigger liability to controlled company.

ERISA:
29 U.S.C. § 1107 (a)(2)

Bankruptcy case law

Sources: United States Code, Department of Labor, Federal Deposit Insurance Corporation, Securities and Exchange Commission, and National Association of Insurance Commissioners.

This is consistent with the views of the Shadow Financial Regulatory Committee, of which I am a member. See Statement No. 199 of the Shadow Financial Regulatory Committee on "SEC Proposals for More Shareholder Democracy," December 8, 2003.

While there is some evidence that states permitting more "direct democracy" have lower growth of state government spending, the evidence on the impact of greater direct democracy is mixed. See John Matsusaka, "Fiscal Effects of the Voter Initiative: Evidence from the Last 30 Years," 103 Journal of Political Economy 3, June 1995. 587-623; John Matsusaka, "Fiscal Effects of the Voter Initiative in the First Half of the Twentieth Century," 43 J. Law & Econ. 619, October 2000; John Matsusaka and Matthew Kahn, "Demand for Environmental Goods: Evidence from Voting Patterns on California Initiatives," 40 J. Law & Econ. 137, April 1997; and John Matsusaka and Nolan McCarty, "Political Resource Allocation: Benefits and Costs of Voter Initiatives," J Law Econ Organ 2001 17: 413-448.

See the not very sanguine analysis of the potential role of public pension fund managers in Roberta Romano, "Public Pension Fund Activism in Corporate Governance Reconsidered," Columbia Law Review, (1993) 93:4, pp. 795-853.

See, for example, Lucian Bebchuk, "Shareholder Access to the Ballot," forthcoming in The Business Lawyer, August 8, 2003, p. 4: "It should be emphasized that the setting of thresholds requirements for shareholder nominations would provide the SEC with a tool for ensuring that shareholder access works well. After the initial setting of the threshold, the SEC will be able subsequently to increase or lower the thresholds in light of evidence."

The Table provides an up-to-date listing of laws and regulations that appear to unduly limit the value of institutional investors' participation in U.S. corporate governance, following Mark Roe, "Political and Legal Restraints on Ownership and Control of Public Companies," Journal of Financial Economics, (1990) 27, 7-41.

For an economic analysis of how equitable subordination and lender liability have shaped US bank involvement in corporate governance, See Randall S. Kroszner and Philip E. Strahan, "Throwing good Money After Bad? Board Connections and Conflicts in Bank Lending," NBER Working Paper No. 8694, December 2001, and "Bankers on Boards: Monitoring, Conflicts of Interest, and Lender Liability," Journal of Financial Economics, December 2001, 62(3), 415-52.

To be sure, commercial banks, financial institutions, and institutional investors may face conflicts of interest when becoming engaged in the management of a company. In work with Philip Strahan, I have investigated linkages between banks and non-financial firms and whether those connections affect lending and borrowing behavior. Our results suggest that avoidance of potential conflicts of interest explains the behavior of bankers in the U.S. corporate governance system. See Randall S. Kroszner and Philip E. Strahan, "Throwing good Money After Bad? Board Connections and Conflicts in Bank Lending," NBER Working Paper No. 8694, December 2001, and "Bankers on Boards: Monitoring, Conflicts of Interest, and Lender Liability," Journal of Financial Economics, December 2001, 62(3), 415-52.

See Chapter 2 of the 2002 Economic Report of the President (Washington, DC: GPO) and Randall S. Kroszner, "The Economics of Corporate Governance for Financial and Non-financial Firms," remarks presented at the Federal Reserve Bank of Chicago, Conference on Bank Structure and Competition, May 8, 2003.